State Issues

August 8, 2012

Viewpoints: Cities can stave off bankruptcies by pre-funding worker benefits

In Aesop's fable, an ant and a grasshopper take two different approaches to confronting the coming winter. While the ant works to gather food for the coming months, the grasshopper idles away the summer.

In Aesop's fable, an ant and a grasshopper take two different approaches to confronting the coming winter. While the ant works to gather food for the coming months, the grasshopper idles away the summer.

Months later, the ant that planned and saved for his future easily survives the winter. The grasshopper that set aside nothing struggles to make ends meet.

The fable's implications about preparing for the future are clear to us on a personal level, so why do we not hold our state and local governments to the same standard?

Take Stockton for example. In the years preceding its recent bankruptcy declaration, Stockton's budget became increasingly burdened by the long-term benefits it owed to its public employees after their retirement.

These benefits included both pension and other post-employment benefits (OPEBs), which mainly comprise retiree health care.

As California Common Sense illustrated in its recent report, "How Stockton Went Bust," Stockton's annual OPEB costs increased 12 percent annually between 2004 and 2010, and it paid these costs directly out of its operational budget.

In 2011, Stockton did restructure its OPEBs and slowed the annual cost increase to 7.5 percent annually. Yet even after restructuring, the annual costs in 2012 will be about $15 million, or more than 9 percent of the city's annual operational budget.

Stockton waited until it was too late to act. In all, the city promised its current and future retirees an estimated $544 million in OPEBs, but it had no assets set aside to fund those promises. Stockton, now in bankruptcy court, is planning to revoke its OPEB promises entirely.

If Stockton had saved and invested money in advance to pay for its retirees' health care, or if it had offered more reasonable terms to its employees, it could have protected retiree benefits. Instead, upon filing for bankruptcy protection, those health care benefits were the first obligations to go.

Health care costs are growing at three times the rate of inflation nationally, and California's state employee OPEB costs have doubled twice in the past decade. This increase makes it especially important for cities and the state to deal with the issue now, either by setting aside funds, or by adjusting contribution or benefits terms for new government employee hires.

Local governments have been trying to reduce or even revoke their existing OPEB promises in San Diego, Orange County, and now Stockton.

But employees facing revocation of their benefits are challenging these moves in court.

With mixed results, the governments have argued that the benefits are not "vested," or guaranteed. In San Diego, the ruling was that OPEBs are not vested. In the Orange County case, the California Supreme Court ruled that they may be.

Other major cities are actually taking steps to pre-fund their future OPEB obligations.

In its recent financial analysis of California's 20 largest cities and the state of California, California Common Sense found that nine of the cities have established trusts to save money for future benefits now.

However, 11 of the cities and the state continue to pay these benefits from their operational budgets on a pay-as-you-go basis (only covering costs as they come).

Sacramento is one of these cities. Although its annual benefit cost growth has been modest, it could nevertheless save over $100 million over the next several decades if the city moves toward pre-funding those benefits.

As OPEB costs grow, they will continue to squeeze out spending in other portions of the budget, such as infrastructure, education and other essential services.

Indeed, San Francisco is already devoting 6 percent of its general fund budget to annual OPEB costs, up from 4 percent in 2008. The city is facing a total $4.4 billion in OPEB promises, a number that continues to grow under its pay-as-you-go system.

But as California Common Sense's report points out, if San Francisco were to switch to a pre-funding plan, it might pay $1.67 billion less in the long run.

Pre-funding contributes to a long-term reduction in annual OPEB costs because investment returns make up for funds a government would otherwise spend on OPEBs directly each year.

But investment returns are not guaranteed. For that reason, the true value of pre-funding is that it ensures that sufficient funding is actually available to provide these promised benefits to retirees in the future.

Pre-funding OPEB obligations will not eliminate all of the uncertainty surrounding the growing cost of retiree benefits, but, surely in this situation, California's governments should strive to be the proverbial ants, not the grasshoppers.

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